Options are a kind of security whose price is intrinsically linked to the price of something else. When a trader buys an option, he has the right but is not obligated, to buy/sell an underlying asset at a given price on or before a given date. There exist two kinds of options - a call and a put option. The former gives the trader the right to buy stock, whereas the latter allows him to sell stock. There exist many types of options strategies that an investor can choose from. One such is known as strangle. Read on to know more about it and how one can get the maximum benefit from this option strategy.
What is a Strangle?
An options strategy wherein the investor holds a position in both a call and a put option with the same expiration date and underlying asset, but with different strike prices are known as a strangle. Usually, the strike price of the call is higher than that of the put. In cases where the reverse occurs, it is known as guts.
If a trader feels that the underlying security will go through a large price movement in the near future but doesn’t know exactly in which direction, then going long/buying a strangle is a good option. It is, however, profitable only if there is a sharp swing in the price.
How Does a Strangle Work?
A strangle strategy involves the purchase of a call option at a price which is higher than the current price and a put option at a price which is lower than the current price. What needs to be remembered is that during the purchase, they both need to be out-of-money. Once this is done, all that is needed is a strong movement in either direction. The direction can be on any side - if there is a price rise, the call will profit, and if it drops, then the put. In short, if the underlying asset keeps moving in one direction, the strangle strategy will continue to profit.
Long vs Short Strangle
Long Strangle
This strategy is used more commonly. Herein the trader buys an out-of-the-money call and an out-of-the-money put option. The strike price of the former is higher than that of the underlying asset's current market price, while that of the latter is lower. In a long strangle, the call and the put options have the same expiry date as well as the same security, such as index, commodity, currency, and interest rates.
This strategy carries with it the possibility of a large profit potential. This is because, in theory, the call option has unlimited upside if the price of the underlying asset rises. The put option can bring in profit if the asset price drops.
The risk involved in a long strangle is limited. The maximum loss that can be incurred is the cost of the options. This occurs when the price of the underlying lies between the strike prices of the call and the Put option on expiry.
The best time to buy the call and put options is when they are undervalued/discounted/out-of-money. This is irrespective of where the spot price of the security moves.
Short Strangle
In this strategy, the trader sells an out-of-the-money put and an out-of-the-money call simultaneously. It is a neutral strategy, and the profit potential is limited. Here, the call and put options have the same expiry date and same security but different strike prices.
It profits when the price of the underlying stock that is being traded operates in a narrow range which lies between the breakeven points. The maximum profit that a short strangle can bring in is equivalent to the net premium that is associated with the writing of the two options, less the trading costs.
Usually, short strangles show asymmetrical risk profiles wherein larger possible maximum losses are seen as compared to the maximum gains to the upside.
In this strategy, the best time to sell the options is when they are overvalued or slightly out-of-money. This is irrespective of which direction the security spot price moves and how much the movement will be in the near future.
When a short strangle does not result in any more profits and gets biased in one direction, the investor generally adds more puts or calls against the position so that original neutral exposure is restored.
Strangle vs Straddle
A strangle, and a straddle are both options which an investor can benefit from based on how stock prices move. Both these strategies involve buying the same number of call and put options with the same expiry date. However, they do have their differences.
- Strike price - A strangle uses options at different strike prices, while a straddle uses them at the same strike price.
- Out-of-money options - A strangle considers out-of-money options while at-the-money options are used in a straddle.
- Directional bias - A strangle is chosen by an investor if he feels that the stock will move in a certain direction but wants to protect himself in case of a negative move. A straddle, on the other hand, has no directional bias.
- Expensive - The buying of a strangle is not as expensive as a straddle because it trades out-of-money.
- Risk - As compared to a strangle, a straddle carries with it more risk because the underlying asset needs to move much more to be able to generate a profit.
- Profitability - A strangle comes with unlimited profitability when the prices move considerably in either direction.
Example of Options With Payoff Curve
To understand the profit and loss associated with a strategy, payoff diagrams are used. So, a payoff diagram, sometimes also called a risk graph, can be defined as the graphical representation of the potential outcomes of a strategy. Though the graphical lines, or the payoff curves, generally depict the results at the expiry of the options involved in the strategy, depiction at a given point in time is also possible.
Check the diagram here (We draw a similar one here?): https://corporatefinanceinstitute.com/resources/wealth-management/payoff-graphs-vs-profit-loss-diagrams/
- The x-axis of the graph represents the call or put stock option’s spot price, whereas the y-axis represents the profit/loss that accrues from the stock options.
- A zero level is marked on the vertical axis. The horizontal point drawn from this point is the stock price.
- All amounts above this zero level indicate a profit, and all below indicate a loss. Other than this, there is a line which is the profit and loss line.
- The point where the profit and loss line intersects the stock price line is called the break-even point. This is the point where there is no profit and no loss.
A payoff diagram can show a long call option, a long put option, a short call option, and a short put option. These are the four basic situations that are associated with options trading. One such example is the iron condor strategy
It is when a call and a put option are sold and bought at the same time. In this strategy, only a limited amount of profit can be earned. However, if the option stock price shows a considerable increase/decrease beyond the limits, then losses will begin to get incurred.
How to Implement Strangle with uTrade Algos
Options trading is not a simple process, and options trading is not for everyone. However, using a strangle, which is an improvisation of a straddle, can bring in a lot of profits for the trader. Hence, using the strategy intelligently will surely be advantageous to the investor.
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